Regulators have been spooked by the possibility of default on large loans to highly leveraged businesses for the past few years, but they are now beginning to worry that such defaults could cause systemic shock waves.

To date, federal agencies have focused mostly on the credit quality of leveraged loans, warning banks that heated competition is weakening underwriting standards.

But they are now starting to show interest in how ties between leveraged loans and other links in the systemic chain - including investment funds that buy up loans - could magnify credit losses.

The Financial Stability Oversight Council - charged by the Dodd-Frank Act to identify systemic threats - heard a closed-door presentation last month from Federal Reserve Board staff on "speculative-grade debt markets, including leveraged lending," according to an official summary from the meeting. It was the second time the FSOC had asked regulators for a briefing on the issue.

"There has always been a certain amount of leveraged lending that was outside the banking system. But now that there are vehicles that are publicly traded, that creates liquidity concerns," said Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods. "That's one of the reasons the FSOC is looking at it."

It is unclear how serious the oversight council is about exploring systemic risks from leveraged loans - usually loans to a company in the millions of dollars shared by multiple banks. Some believe the risk is minor compared with other activities with a bigger footprint and steps institutions have taken to avert catastrophe.


But demand for leveraged loans, though still elevated, actually went down last year, suggesting investors may be cooling to the market. In the Fed's most recent senior loan officer survey, released earlier this month, 22% of respondents, and 27% of those representing large banks, said they expected some deterioration over the next year in syndicated leveraged commercial loans.

Experts say the council's interest in leveraged lending channels is not surprising given regulators' concerns about how quickly loans grew in recent years and similarities with recently maligned distribution models, such as mortgage securitization. (Under Dodd-Frank, the council can recommend stricter standards from member regulators for activities threatening financial stability.)

"I don't know that it means that they're contemplating action as much as that they're doing what they should be doing, which is looking at an issue that a lot of people fear could - particularly in the continued lower interest rate environment - pose potential risk," said Karen Shaw Petrou, managing partner at Federal Financial Analytics. "Money is chasing yield, which means it's chasing risk. In the event that this blows, the question is where does the bouncing ball end?"


Experts say officials are likely interested in leveraged loan mutual funds, which attract ordinary investors in a low-rate environment and promise quick redemptions, and other more complex investment instruments. Another potential concern is whether large banks that sell leveraged loans may still have risk. In the financial crisis, mortgage-related exposures thought to be removed from banks' balance sheets came back to bite them.

"My guess is FSOC would be most concerned about what the banks are exposed to, either directly or by holding the loans on their balance sheet or indirectly by having provided credit to" institutions that purchased them, said Arthur Wilmarth, a George Washington University law professor. 

Overall leveraged loans went down last year by 17% to $940 billion, but that is still very robust following the huge spike in originations starting in 2010. 

Meanwhile, loan mutual funds - usually made up of leveraged loans - accounted for about 16% of the $850 billion institutional loan market in December, according to the Loan Syndications and Trading Association. Meredith Coffey, the LSTA's executive vice president for research, said while questions about potential systemic risks could be expected, she doubts regulators will find anything.

Coffey noted that the leveraged lending market is less than 2% the size of the capital markets overall, and other sectors pose greater macroeconomic concerns. Whereas the mortgage sector could be dragged down by just one area - housing - Coffey said securities backed by leveraged loans finance numerous sectors and therefore lack the same type of risk.

But others note aspects of the leveraged lending market that they say could amplify the risk. While more sophisticated investors can invest in leveraged loans through channels such as collateralized loan obligations, there are also mutual funds and exchange-traded funds backed by the loans.

"Anytime you have this chain of securitization you have this problem of different actors having different incentives. The final risk of the product may be greater than what the investors think it is," said Elisabeth de Fontenay, a Duke University law professor.

She noted that mutual funds' interest in leveraged loans is relatively recent, and unlike with other types of vehicles, mutual funds "have to be able to redeem investors on a dime." That process is complicated by the fact that leveraged loan borrowers typically have to grant permission before a security is reassigned.

"That's really easy to do when you're talking about stocks and publicly traded bonds. It's much harder to do when you're talking about leveraged loans." 

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